CCI Entrepreneurship Curriculum Module 8b – Company Valuation

Content for Unit Introduction to company valuation – useful tools to help you to the value your business. Topics: Time value for money, PV, FV, compounding interest. NPV, discounted payback period (DPB), Internal Rate of Return (IRR). Models for company valuation- CAPM, WACC.

What Investors or Business Angels want back and when? Business value is an expected price the business would sell for. To valuate your business is important as investors usually want their money back in 5 to 7 years time to reinvest. If we consider today’s value of their investment, when they exit, they may want 10 to 20 times more than today, hence this needs to be shown in a business valuation. In brief there are 3 valuation models: Asset Approach Market Approach Income Approach ( A more reliable approach?)!! Source: http://www.valuadder.com/glossary/business-valuation-approaches.html

What Investors or Business Angels want back and when? Asset Approach Asset accumulation method http://www.valuadder.com/glossary/asset-accumulation-business-valuation.html Capitalized excess earnings method Business Value = Assets + Business Goodwill Market Approach- see: http://www.valuadder.com/glossary/business-valuation-approaches.html Comparative transaction method Guideline publicly traded company method Income Approach ( A more reliable approach?)!! Discounted cash flow method Capitalization of earnings method Multiple of discretionary earnings method Source: http://www.valuadder.com/glossary/business-valuation-approaches.html

Time Value for Money What is the 'Time Value of Money - TVM' ‘ The time value of money (TVM) is the idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. TVM is also referred to as present discounted value’. Basic Time Value of Money Formula and Example Depending on the exact situation in question, the TVM formula may change slightly. For example, in the case of annuity or perpetuity payments, the generalized formula has additional or less factors. But in general, the most fundamental TVM formula takes into account the following variables: FV = Future value of money PV = Present value of money i = interest rate n = number of compounding periods per year t = number of years Based on these variables, the formula for TVM is: FV = PV x (1 + (i / n)) ^ (n x t) For example, assume a sum of $10,000 is invested for one year at 10% interest. The future value of that money is: FV = $10,000 x (1 + (10% / 1) ^ (1 x 1) = $11,000 The formula can also be rearranged to find the value of the future sum in present day dollars. For example, the value of $5,000 one year from today, compounded at 7% interest, is: PV = $5,000 / (1 + (7% / 1) ^ (1 x 1) = $4,673 Source: ttp://www.investopedia.com/terms/t/timevalueofmoney.asp

How to find FV,PV Compounding Interest? Basic Time Value of Money Formula: FV = Future value of money PV = Present value of money i = interest rate n = number of compounding periods per year t = number of years Based on these variables, the formula for TVM is: FV = PV x (1 + (i / n)) ^ (n x t) Basic Time Value of Money Formula and Example Depending on the exact situation in question, the TVM formula may change slightly. For example, in the case of annuity or perpetuity payments, the generalized formula has additional or less factors. But in general, the most fundamental TVM formula takes into account the following variables: FV = Future value of money PV = Present value of money i = interest rate n = number of compounding periods per year t = number of years Based on these variables, the formula for TVM is: FV = PV x (1 + (i / n)) ^ (n x t) For example, assume a sum of $10,000 is invested for one year at 10% interest. The future value of that money is: FV = $10,000 x (1 + (10% / 1) ^ (1 x 1) = $11,000 The formula can also be rearranged to find the value of the future sum in present day dollars. For example, the value of $5,000 one year from today, compounded at 7% interest, is: PV = $5,000 / (1 + (7% / 1) ^ (1 x 1) = $4,673 Effect of Compounding Periods on Future Value The number of compounding periods can have a drastic effect on the TVM calculations. Taking the $10,000 example above, if the number of compounding periods is increased to quarterly, monthly or daily, the ending future value calculations are: Quarterly Compounding: FV = $10,000 x (1 + (10% / 4) ^ (4 x 1) = $11,038 Monthly Compounding: FV = $10,000 x (1 + (10% / 12) ^ (12 x 1) = $11,047 Daily Compounding: FV = $10,000 x (1 + (10% / 365) ^ (365 x 1) = $11,052 This shows TVM depends not only on interest rate and time horizon, but how many times the compounding calculations are computed each year. Source: http://www.investopedia.com/terms/t/timevalueofmoney.asp

How to find FV,PV Compounding Interest? Basic Time Value of Money Example For example, assume a sum of $10,000 is invested for one year at 10% interest. The future value of that money is: FV = $10,000 x (1 + (10% / 1) ^ (1 x 1) = $11,000 The formula can also be rearranged to find the value of the future sum in present day dollars. For example, the value of $5,000 one year from today, compounded at 7% interest, is: PV = $5,000 / (1 + (7% / 1) ^ (1 x 1) = $4,673 Taking the $10,000 example above, if the number of compounding periods is increased to quarterly, monthly or daily, the ending future value calculations are: Quarterly Compounding: FV = $10,000 x (1 + (10% / 4) ^ (4 x 1) = $11,038 Basic Time Value of Money Formula and Example Depending on the exact situation in question, the TVM formula may change slightly. For example, in the case of annuity or perpetuity payments, the generalized formula has additional or less factors. But in general, the most fundamental TVM formula takes into account the following variables: FV = Future value of money PV = Present value of money i = interest rate n = number of compounding periods per year t = number of years Based on these variables, the formula for TVM is: FV = PV x (1 + (i / n)) ^ (n x t) For example, assume a sum of $10,000 is invested for one year at 10% interest. The future value of that money is: FV = $10,000 x (1 + (10% / 1) ^ (1 x 1) = $11,000 The formula can also be rearranged to find the value of the future sum in present day dollars. For example, the value of $5,000 one year from today, compounded at 7% interest, is: PV = $5,000 / (1 + (7% / 1) ^ (1 x 1) = $4,673 Effect of Compounding Periods on Future Value The number of compounding periods can have a drastic effect on the TVM calculations. Taking the $10,000 example above, if the number of compounding periods is increased to quarterly, monthly or daily, the ending future value calculations are: Quarterly Compounding: FV = $10,000 x (1 + (10% / 4) ^ (4 x 1) = $11,038 Monthly Compounding: FV = $10,000 x (1 + (10% / 12) ^ (12 x 1) = $11,047 Daily Compounding: FV = $10,000 x (1 + (10% / 365) ^ (365 x 1) = $11,052 This shows TVM depends not only on interest rate and time horizon, but how many times the compounding calculations are computed each year. Source: http://www.investopedia.com/terms/t/timevalueofmoney.asp

NPV, DPB, IRR NPV DPB IRR Sources: Videos: http://www.investopedia.com/terms/n/npv.asp http://www.investopedia.com/video/play/discounted-payback-period/ http://www.investopedia.com/video/play/understanding-internal-rate-of-return/ Run the NPV video form Investopedia: http://www.investopedia.com/terms/n/npv.asp ( 1.3 min) Run the DPB video from Investopedia: http://www.investopedia.com/video/play/discounted-payback-period/ ( 1.22 min) Run IRR video form Investopedia: http://www.investopedia.com/video/play/understanding-internal-rate-of-return/ ( 1.30 min) Run through two examples on the next 3 slides.

NPV, DPB, IRR How to find it DPB is simply discounting the amounts ( cash flows) and finding the time the investment is recuperated.  IRR= rmin+(Rmax-rmin)xNPV(+)/[NPV(+) - NPV(-)] ( see the IRR function in Excel) Which is better NPV or IRR? Source: http://www.investopedia.com/video/play/capital-budgeting-which-better-irr-or-npv/ Run the NPV video form Investopedia: http://www.investopedia.com/terms/n/npv.asp ( 1.3 min) Run the DPB video from Investopedia: http://www.investopedia.com/video/play/discounted-payback-period/ ( 1.22 min) Run IRR video form Investopedia: http://www.investopedia.com/video/play/understanding-internal-rate-of-return/ ( 1.30 min) Run through two examples on the next 3 slides.

NPV Usage in Business Valuation Example: Given the cash flows for Power Manufacturing Division, calculate the PV of near term cash flows, PV (horizon value), and the total value of the firm. r=10% ( discount rate) and g= 6% (constant growth rate). Suppose this growth starts after year 7. NPV example and Value of the business 21. Decision: Suppose someone offers you for Power Manufacturing Division $20.5, then you take the offer, if the offer is less then $18.8, then you reject the selling of this division

Discounted Payback use in Business Example: Examine the three projects and note the mistake we would make if we insisted on only taking projects with a payback period of 2 years or less. DPB example! Decision: Chose the project with positive NPV and within 2 years DPB.

Internal Rate of Return Use Example Calculating the IRR can be a laborious task. Fortunately, financial calculators can perform this function easily in Excel (simply use IRR (:) ) For example if we borrow to invest in the building at 20% interest rate from the bank, the cash flow pattern emerging form the business renting and selling has to yield more than 20% as IRR so we can cover our cost with the interest. If this is not happening, than we can negotiate the rates more with the bank or increase the rent until IRR>O.CC (meaning IRR> the discount rate). IRR example in Excel, use the function and the approximation formula! Decision: Chose projects with IRR more than the cost of capital or of the funds if borrowed, but chose the project with the highest NPV, even if IRR is lower, as long as IRR exceeds the cost of capital.

Models for company evaluation- CAPM, WACC What is CAPM? Source: http://www.investopedia.com/terms/c/capm.asp What is Beta? Source: http://www.investopedia.com/video/play/understanding-beta/ What is WACC? Source: http://www.investopedia.com/video/play/what-is-wacc/ and http://www.investopedia.com/video/play/cost-capital/ Run the videos on CAPM, Beta and WACC, then apply in a case study in the next slide! On the right hand side of the current slide are the formulas Run a practical example on the Case study example on the next slide!

Models for company evaluation- CAPM, WACC CAPM formula: WACC formula : (E/V) x Re + (D/V) x Rd x (1 –Tc) Re = cost of equity Rd = cost of debt E = market value of the firm’s equity D = market value of the firm’s debt V = E + D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate Run the videos on CAPM, Beta and WACC, then apply in a case study in the next slide! On the right hand side of the current slide are the formulas Run a practical example on the Case study example on the next slide!

Models for Company Evaluation- CAPM, WACC - Case Study The total market value of common stock of Marlin Ballet Company in Cyprus is €6 million and the value of total debt is €4 million. The treasurer estimates that the beta of the stock is currently 1.5 and the expected risk premium on the market is 9%. The risk free rate is 8% and we assume for simplicity that Marlin Ballet Company ‘s debt is at risk free. Assume no taxes either. Questions: a. Estimate what is the required return on Marlin Ballet Company’s stock? b. What is the beta of the company’s existing portfolio of assets? c. Estimate the company cost of capital? Run a Case study example on this slide! Solution explained: a. CAPM => R=8%+1.5*9%=21.5% - by using CAPM formula b. Basssets=1.5 *6/10 + 0* 4/10= 0.9- by using WACC formula c. CAPM => R=8%+0.9*9%= 16.1%- by using CAPM formula for the company Beta not only the stock beta. So, therefore only for company expansion of the same business, but not for completely new ventures , the firm can use as discount rate the 16.1% !

Models for Company Evaluation- CAPM, WACC - Case Study The total market value of common stock of Marlin Ballet Company in Cyprus is €6 million and the value of total debt is €4 million. The treasurer estimates that the beta of the stock is currently 1.5 and the expected risk premium on the market is 9%. The risk free rate is 8% and we assume for simplicity that Marlin Ballet Company ‘s debt is at risk free. Assume no taxes either. a. Estimate what is the required return on Marlin Ballet Company ‘s stock? b. What is the beta of the company’s existing portfolio of assets? c. Estimate the company cost of capital? Run a Case study example on this slide! Solution explained: a. CAPM => R=8%+1.5*9%=21.5% - by using CAPM formula b. Basssets=1.5 *6/10 + 0* 4/10= 0.9- by using WACC formula c. CAPM => R=8%+0.9*9%= 16.1%- by using CAPM formula for the company Beta not only the stock beta. So, therefore only for company expansion of the same business, but not for completely new ventures , the firm can use as discount rate the 16.1% ! Solution: a. CAPM => R=8%+1.5*9%=21.5% b. Basssets=1.5 *6/10 + 0* 4/10= 0.9 c. CAPM => R=8%+0.9*9%= 16.1%

Case Study 1 - Problem Suppose your accountant provides you with the following projections of your financial statements. An investment fund wants to make an offer to for your business. Explain in which conditions would you sell your business. Suppose your firm total market value of common stock today is now €6 million and the value of total debt is €4 million. The treasurer estimates that the beta of the stock is currently 1.25 and the expected risk premium on the market is 10.67%. The risk free rate is 2% and we assume for simplicity that your firm’s debt is at risk free. Assume 12.5% tax rate.

Case Study 1 - Solution Step 1. Find the discount rate CAPM => Requity=2%+1.25*10.67%=15.33% WACC=> Rassets= 15.33%*(6/10)+ 2%*(1-12.5%)*4/10=9.2%+0.7%=9.9%- this is the company discount rate in case of expanding the same line of business. (approx. 10% is your free cash flows discount rate), sure you can adapt this in case you consider risk is higher, based on additional risk elements. Step 2. Identify the growth rate ( the growth of the EPS when it starts to become constant, hence after year 6), so g=6%. Step 3. Calculate the NPV of the business in two steps: Calculate Present value horizon: Calculate the PV of the near cash flows: the Decision : If the NPV of the business is more than the offer you will not sell the business.

Case Study 2 - Problem What is the NPV of this project? In how many years would they recuperate their investment, if supposed that the investment is as per the table below, consider 10% discount rate. What is the IRR of the investment considering the data below. (make use of excel).

Case Study 2 - Solution y0 y1 y2 y3 y4 Investment/ CF -120 -150 270   y0 y1 y2 y3 y4 Investment/ CF -120 -150 270 300 400 PV= - 120.00 - 136.36 223.14 225.39 273.21 NPV= 465.38 IRR 68% Part of the last year required to pay off =-0.1474 Discounted Pay back period from today 2.1474 years

Summary What we covered? How we use it? Unit 1 - Introduction to valuation for companies – useful tools to help you to asses the value your firm ………………… The trainer asks the participants on each unit the most important aspects and why they think they can use them in their business. This is an interactive part.